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How to Gauge the Credit Risk of Bank Loans: Evidence from Taiwan

by Kuang-Erh Lai of National Sun Yat-sen University, and
Chau-Jung Kuo of National Sun Yat-sen University

May 2010

Abstract: We put into considerations the practical differences between loan and bond to modify and extend Merrick's credit risk model on bonds, and apply the assumption of risk-neutral to estimate jointly the default probabilities and recovery rate of a bank loan. Based on the empirical results from a case Bank, we show that high (low) implied default recovery rate should result jointly in high (low) implied default rate. In addition, the result also shows that it should be helpful for banks to reduce the credit risk through diversified loan types. Finally, with the simplicity of jointly reach the default probability and recovery rate of any specified loan groups using only both loan information and riskless rates, our model can provide a feasible solution for financial institutions needed to adopt internal rating-based approach under the new Basel Capital Accord.

JEL Classification: G32.

Keywords: Credit risk, Internal-rating based approach, New Basel Capital Accord.

Published in: International Research Journal of Finance and Economics, Vol. 39, (May 2010), pp. 7-14.

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